FNP: Where Do We Go Now?

Takeaway:If you own FNP for a transaction, you should get out. The call is bigger than that. The upside is there under both scenarios.

The single greatest takeaway from this FNP quarter is that the 17% top line growth rate is the highest we've seen out of the company since March 2003. We cringe every time an analyst congratulates a management team on a conference call (do any of us get publicly congratulated for doing our jobs?) -- but we gotta hand it to McComb. This quarter was a big step forward for FNP.

All of that said, this stock has been one of the best performers in the market over the past 6, 12, and 24-month time periods. It's been one of our favorites all along. But with the stock at $21 we need to step back and really re-evaluate where we can go from here. The answer, we think, is 'higher'.

We think we need to tear apart the model and look at two scenarios. 1) FNP as is today, with Juicy and Lucky as part of the portfolio, and 2) what the model will look like on that day the company announces that it's selling 55% of its revenue (but only 25% of next year's EBITDA). We think many people will be surprised to see that the profitability levels don't look dramatically different under both scenarios. The difference, however, is in the flexibility to maximize and optimize the amount of capital allocated towards highest-return businesses.

SCENARIO 1: FNP REMAINS INTACT

Contrary to what many people think, we're not against FNP abandoning its efforts to sell Juicy and Lucky. Yeah, the stock would take a hit due to people renting it for the deal. But here are our assumptions...

a) Juicy: The reality is that we're convinced that Juicy has hit a bottom, and the new initiatives coming down the pike over the next 12 months (like outlet redesign and Juicy Sport -- it's answer to Lululemon) have very minimal downside for the brand and its cash flow. Even if we assume that it stabilizes comps, adds minimal square footage, and returns to a (still paltry) sub-8% EBITDA margin, we get to a 5-year EBITDA growth CAGR of about 25%. It's not a slam dunk, as we need to see the new org chart at Juicy execute on the hype. But we think that our assumptions are hardly heroic.

b) Lucky: This is a brand that we think has meaningful upside under FNP's umbrella. We think that having a sister brand like Kate pave the way to grow outside of traditional denim categories could take productivity well above management's stated goal of $600/square foot. After square footage shrank over the past three years, we think we're finally going to see a reacceleration in store growth, and will see the company once again break through the 10% EBITDA margin mark.

c) Kate: There's not much that hasn't been said here. Management subtly took up square footage growth goals on this conference call (10 outlets for this year up to 10-12, and 30 US Specialty stores up to 30-35), which is a drop in the bucket relative to the 300 stores that the company is likely to add globally over a 3-4 year time period. Seriously, the store growth potential here is very difficult to find in retail. We're often asked what gives us the confidence that it can grow at this clip -- and one of our answers is that it is currently running at just a low double digit operating margin. Brands like Coach and Kors are hovering around 30% (ie we need to ask the question of whether they are investing enough capital to sustain brand momentum and allure). Same goes for other high margin concepts like LULU. But this is not the case with Kate. In fact, after it is done with its multi-year investment phase, we should see EBITDA margins climb past 20% (EBIT margins still in teens), which should make profitability explode. In short, we have Kate's EBITDA going from $94mm in 2012 to $425mm over a 5-year time period, with comps and unit growth fueling the early years, and margin improvement (up to 22% EBITDA margins) driving the back-end of the model.

d) Total Company: Bottom line, EBITDA from $106mm to nearly $500mm over 5-years . It will not have the cash flow to start paying down debt until 2015 given the step-up in capex in 2013 and the absence of what would likely be $600mm+ from the sale of Juicy/Lucky. But on the flip side, it still likely has a good three years until it has to pay cash taxes due to NOL carryforwards, which serves as a big offset to interest expense. On a fully taxed basis, FNP should break-even this year excluding streamlining charges, and then ramp at a precipitous rate thereafter -- with an extra $0.40-$0.60 per share in earnings per year through 2017. Perhaps the most telling statistic is FNP's RNOA. It has not earned its cost of capital since 2006 -- and that was a fluke due to the operating environment. Previous peak RNOA was 17%, which happened when the company was using a low cost of borrowing to roll up the industry. But over the next 5-years, the new FNP should see its returns in the 70-80% range. Not a bad return on capital by any stretch.

SCENARIO 2: FNP SELLS JUICY AND LUCKY

We think we can safely assume that FNP sells both Juicy and Lucky for a combined $600mm. We're going to ignore what the press is saying for the time being (which would get us to a higher valuation) -- as we don't want to fall victim to bankers negotiating a transaction through Deal Reporter or Women's Wear Daily. If we look at 2013 numbers, we think that $300mm-$350mm is fair for Lucky, and $250mm is fair for Juicy. Interestingly enough, when all is said and done, the earnings numbers don’t look much different whether FNP owns these two divisions or not. The offsets to losing Juicy and Lucky's EBIT are a) $383mm in debt goes away, which saves about $50mm in interest expense, b) D&A comes down by about 40%, and c) both stock-based comp and unallocated corporate costs come down by 10-20%.

So the question then, is 'why do the deal'? The answer comes down to the balance sheet, as eliminating $383mm in in debt definitely means something. In addition, at any given point, the company has over $100mm in capital tied up in inventories at Juicy and Lucky, as well as what we think is $10-$20mm in maintenance capex in those two concepts. In the end, this is not a balance sheet killer for FNP. But when you're painting a picture of a $4bn ultimate brand roadmap, there's something to be said about keeping capital flowing towards the highest margin and highest return opportunities.

WHAT TO DO WITH THE STOCK

If you're in it for a transaction, then we'd suggest that you get out. It's not the right reason to own it at this point in time. You should be buying FNP today for one reason…and that's because you think that the Kate Spade brand can triple its store size globally, build out its e-commerce business, and layer on additional concession shops at a rate such that revenue grows 4-5x in 5 years without having to make assumptions that Kate ever prints an operating margin above 20%. With this kind of brand growth, we should see the company handily beat consensus whether they sell Juicy/Lucky or not. Would we rather see the brands go? For the right price, yes. But it's not imperative to the underlying call. Until the Street realizes our modeled earnings power and EBITDA trajectory, we're not concerned about valuation. It is trading today at 30-35x next year's earnings. Yeah, that's high. But for a company growing earnings well in excess of 30% while the balance sheet continues to de-risk itself and returns head from 0% to 70%...we'd give pretty big pushback to anyone who is short and making a valuation call.

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05/03/13 12:56 PM EDT

JOBS DATA POSITIVE FOR RESTAURANTS

In line with the Hedgeye Macro Team’s call, this morning’s April jobs data was indicative of a continuing bullish trend in the U.S. economy. The narrower data sets released along with the headline numbers were, on balance, positive for the restaurant space as accelerated employment growth in younger age cohorts suggests that sales at QSR and fast casual are likely to remain strong into 2Q.

Employment by Age

Employment growth by age data continue to imply that quick service restaurants are benefiting from improving job growth in the younger age cohorts while casual dining also benefitted (albeit to a lesser degree) from a sequential improvement in the employment growth rates in older age cohorts. The sequential acceleration/deceleration in employment growth among the respective age cohorts illustrated below ranged from -60 bps (25-34 YOA) to +162 bps (20-24 YOA). We would highlight that employment growth among the youngest age cohort in the chart below is frequently referenced by companies and industry operators as being crucial for restaurants chains’ top line growth.

We remain bullish on SBUX, CAKE, DRI, and JACK, and are bearish on BWLD, MCD and PNRA.

Industry Hiring

The Leisure & Hospitality employment data, which leads the narrower food service data by one month, suggests that employment growth in the food service industry may have ticked up in April, consistent with the commentary of several management teams during the recent earnings period. On a sequential basis, Leisure & Hospitality employment data registered a month-over-month gain of 43k (second chart below), an acceleration from the prior month’s 38k month-over-month gain.

Limited Service: Employment growth at +4.1% in March, down 60 bps versus February

Full Service: Employment growth at +1.6% in March, down 22 bps versus February

Howard Penney

Managing Director

Rory Green

Senior Analyst

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05/03/13 11:52 AM EDT

HST 1Q13 CONF CALL NOTES

Takeaway:Continue to like the lodgers. Still a lot of gas in the tank for this cycle

Another solid earnings report from a hotel company. Sorry Hyatt.

The Company's owned hotel revenues increased 4.6% for the first quarter of 2013.... due to the strong performance of its comparable properties, as well as incremental revenues of $21 million from the Grand Hyatt Washington, which was acquired in July of 2012. The increase in comparable hotel RevPAR as adjusted was primarily driven by strong improvements in average room rates. For the first quarter, average room rates improved 4.0%, while occupancy improved 0.7 percentage points to 72.3%. The improvements in revenues led to solid margin growth as comparable hotel adjusted operating profit margins increased 85 basis points"

CONF CALL NOTES

2013 is off to a strong start.

Timing of the Easter and Passover holiday presented challenges for the month of March

Calendar challenges lead to a reduction of F&B revenues

YoY RevPAR growth %s would have been 100bps higher if 2012 had not been a leap year

Solid increases in transient ADR's lead the outperformance in the quarter with revenues from this segment increased more than 10% in the Q.

4.5% increase in rate; adjusted for the leap year demand was also up in all 3 months and highest premium rated segment was up 13%

Resorts locations benefited from the holiday shift with RevPAR up 11.6%

Group front - Jan started strong with a 3% increase in room nights and a rate increase of 3.5%. Feb demand was flat but average rate was up 1%, in March volume in the final week fell 45% - resulting in a 12.5% decline for the month.

Overall, group demand adjusted for the leap year declined by nearly 4%, but from a segment perspective, high priced corporate business increased. Decline was driven by reductions in discount business, which included a few cancellations (including from government and government related groups). A decrease in short-term government bookings contributed to the shortfall.

Booking activity in 1Q was weak (revenues down 2.5%), but is up 3% for the balance of the year with revenues looking up 6%. 2Q & 4Q look good but 3Q is flat. Bookings for 2014 picked up nicely in 1Q14 suggesting that they are seeing a lengthening of the booking window. At this point 85% of group bookings for 2013 are under contract for the year.

Continue to be active on the M&A front as they look to increase exposure in core markets while reducing exposure in non-core markets. Expect to be a net acquirer.

Anticipate acquisition activity of $135-150MM in 2Q but this is not in guidance

Dividends for the balance of the year will depend on asset sales and operating results

Geographic color:

San Antonio: +16.6% (Occ +4%, ADR+10%) Group mix shifted to higher rated association and corporate business. Expect to have a weaker second quarter and then perform better in the second half of the year due to strong city wide bookings.

Boston: +14.2% The outperformance was driven by in-house group demand, which created compression to drive rate. Expect a good 2Q due to solid in-house group bookings.

NY: +12.1% (occupancy increased 8%): Overseas arrivals were very strong. 1/3 of all US arrivals come to NY. Benefited from easy renovation comps. But still had final phase of some renovations. Expect continued good performance.

Houston: +11.8% substantially driven by improvements in ADR from both rate increases and the shift in the mix of business for higher-rated segment as both group and transient demand were strong. Continue to perform well in 2Q due to solid group and transient booking.

Hawaii: +8.4% due to strong group and transient demand, which drove rate growth to 5%. Expect continued good performance in 2Q

Seattle: 7.6% transient demand was very strong. Expect great 2Q due to excellent group bookings.

Washington: +2.3%.Downtown hotels performed much better than the suburbs with RevPAR up 5.3%. Expect DC to continue to struggle due to weakness in government and government related travel somewhat stemming from the sequester.

San Fran: -2.5% due to renovations (occ down 4%). RevPAR for the Marquis was down 13% and excluding this asset, RevPAR would have been up 6.7%. Expect better performance in 2Q.

San Diego: (Occ -4.6%/ ADR -2%) Struggled in the first quarter due to poor citywide demand and were affected by rooms renovations at three of our hotels in the quarter. Expect better performance next Q.

Expect RevPAR to be driven primarily by rate growth in the balance of the year. Expect better F&B revenues and profits. Expect support costs to increase above inflation, particularly for rewards and sales and marketing where higher revenues will increase cost and for utilities where they expect rates to increase, particularly in the second half of the year.

Expect 30-32% of their EBITDA to be earned in 2Q

Cash interest expense run rate of $230MM/ year currently

Q&A

Gap between comp and non-comp revenue? Strong performance of hotels that they have invested capital in and hotels that they have purchased ... those hotels had RevPAR growth of 27% in the 1Q. There are also hotels that have moved out of the portfolio. Hotels in the non-comp set should continue to materially outperform their SS comp set.

Rationale for the equity issuance. They are relatively confident that they will close on a few assets in 2Q - so the equity issuance was in anticipation of that. They are anticipating an acceleration on of asset sales later this year and do expect to fund most of the acquisitions out of those proceeds.

They do always look at whether it makes sense to buyback their stock. Feel like it's been more prudent to redeploy cash in acquisitions. In the future if they have more sales than purchases they may consider buying stock.

Feel good about the length of the cycle and the progress they have made on the balance. They are likely to begin funding more acquisitions with some debt but not necesssarily at the asset level.

Still feel good about group. There was some weakness in 1Q relative to overall bookings. Some of that is likely due to weakness in government bookings. Saw a fall off in the range of 40% of government bookings.

Today's employment growth gave him more optimism over what they may see in the back of the year

Bulk of the lift in guidance they gave is due to the Newport Beach land gain. 1Q was a little more challenging but they did better than they expected. They don't really have a change in outlook for the balance of the year than they did in Feb though.

Pretty clear that they are interested in the Coastal markets, Chicago and Hawaii. Focus on West Coast ex. San Diego, Hawaii ex. Maui. Interested in Miami on the East Coast. There continues to be a slow flow of assets to the market- not a rush - since people are confident that the cycle will last longer. Transaction activity this year should be comparable to last year.

They are still looking globally for acquisitions. Have $130MM of equity in their Euro JV that needs to be deployed. Focused on N. Europe (Germany in particular). In Asia they like Australia and in LATAM they like Brazil.

Cap rates are 5-6% for top tier assets and about a point wider for limited service

Both associations looking at bigger events and corporate bookings are also better- which are both driving the wider booking window

Group booking for 2014 are up over 6%

Their Rio project is progressing along right on schedule. They are more interested in acquiring existing assets than new build in that market

What % of hotels are paying incentive mgmt fees: 43% forecasted for 2013 vs. low to mid 60's were paying incentive fees in the peak. Don't see any reason why they won't get back to peak levels or higher. Still expect some occupancy growth, but do think that there is a reasonable prospect for even better rate growth in the balance of the year. As long as rate growth is above inflation they should have better margins.

They are interested in acquiring limited service hotels in urban markets. Think it's a natural complement to hotels that they already own.

Getting mid to high teens ROI's on their renovation projects. They never seem to have a shortage of these projects.

There has been a significant improvement in the CMBS market.

On the full service side, assets are still trading at a discount to replacement cost, although that gap has narrowed in some markets that have recovered faster. Limited service in urban market have a smaller gap where new construction may make sense.

Impact from the Healthcare reform? Still unclear. Don't expect a dramatic impact though.

What amount of in the year for the year business is at risk due to the short term sluggishness? DC UUP RevPAR was up 4%. They have a bunch of assets that are outside the DC downtown area. Inside the city they were ahead of where the market was. Their Hyatt Capital Hill was also under renovation so that had some impact as well.

85% of their group business is already on the books for 2013 as of today. Of course some of that is subject to cancellation. Most properties have gone out to their government business to confirm it this past month.

Not really seeing any softness on the rate side. Group Business represents 38-39% of their business. Their transient business is so strong that they may end up with less group than they thought given that they are able to fill those rooms with better rated transient business.

Government business represents about 6% of their room nights split between transient and group

They have been actively trying to reduce their exposure to government.

Bulk of the activity in Europe is occurring due to debt maturities. Yields in Europe vary considerably depending on the city & country. London & Paris are comparable to top us markets. In Germany the target rates are higher.

As the CMBS market recovers there should be more financing support for non-gateway markets

HIGHLIGHTS FROM THE RELEASE

During the first quarter of 2013, the Company recognized a previously deferred gain of approximately $11 million related to the 2005 eminent domain claim by the State of Georgia for 2.9 acres of land at the Atlanta Marriott Perimeter Center for highway expansion. The Company received the cash in 2007 but could not recognize the gain until certain requirements were completed. The gain has been included in NAREIT FFO per diluted share. However, due to the significant passage of time since receipt of the proceeds, the Company has excluded the gain from its Adjusted FFO per diluted share and Adjusted EBITDA for the quarter.

Capex summary:

1Q ROI Capex: $21MM. Projects completed during the first quarter included the development of a pavilion at the JW Marriott Desert Springs Resort & Spa and the conversion of a former restaurant into meeting space at the Westin New York Grand Central.

Acquisition related Capex: $15MM. During the first quarter, the Company completed the renovation of all 888 guest rooms at the Grand Hyatt Washington and continued work on the guestrooms renovation in the second tower of the Manchester Grand Hyatt San Diego.

Maintenance: $87MM. During the quarter, major renewal and replacement projects included rooms renovations at the Philadelphia Airport Marriott, the San Francisco Marriott Marquis and the San Diego Marriott Mission Valley, as well as the renovation of almost 40,000 square feet of meeting and public space at The Ritz-Carlton, Tysons Corner and over 36,000 square feet of meeting space at the Westin Denver Downtown.

In early April, the Company sold approximately four acres of excess land adjacent to its Newport Beach Marriott Resort and Spa to a luxury home builder for $24 million. The land, which had previously been used for tennis courts, has been approved for the development and sale of 79 luxury condominiums. The Company recognized a gain of approximately $21 million, which will be included in net income, Adjusted EBITDA and Adjusted FFO in the second quarter of this year.

Balance sheet items in 1Q13:

Issued its first investment grade senior notes in a $400 million offering of 10-year bonds at an interest rate of 3.75%, which is 100 basis points lower than any non-convertible bond coupon in the history of the Company. The bonds mature in October of 2023. The proceeds of the offering, along with available cash, will be used to redeem on May 15, the $400 million of 9% Series T senior notes due 2017 at 104.5%, which reflects an $18 million call premium. The annual interest savings are $21 million per year.

Called the remaining $175 million of 2004 exchangeable debentures for redemption and holders of approximately $174 million of the debentures elected to exchange their debentures for shares of the Company's common stock totaling approximately 11.7 million shares, rather than receive the cash redemption proceeds, while the remaining $1 million of debentures were redeemed for cash. These shares have been included in our dilutive share count when determining our full year NAREIT and Adjusted FFO per diluted share for the past few years.

Issued 6.1 million shares of common stock, at an average price of $16.78 per share, for net proceeds of approximately $102 million. These issuances were made in "at-the-market" offerings pursuant to Sales Agency Financing Agreements with BNY Mellon Capital Markets, LLC and Scotia Capital (USA) Inc. There is approximately $198 million of issuance capacity remaining under the current agreements.

Subsequent to the end of the quarter, the Company repaid the 4.75%, $246 million mortgage loan on the Orlando World Center Marriott with available cash. The Company also called $200 million of its 6.75% Series Q senior notes due 2016 at 101.125%, which reflects a $2 million call premium. The redemption will be funded through a $150 million draw on the revolver portion of its credit facility and with available cash. After adjusting for these transactions, including the redemption of the Series T senior notes, the Company will have approximately $380 million of cash and cash equivalents, $692 million of available capacity under its credit facility and approximately $4.8 billion of debt.

The Company's weighted average debt maturity is 5.8 years and its annual cash interest expense will be approximately $230 million.

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05/03/13 11:18 AM EDT

Bullish Enough? SP500 Levels, Refreshed

Takeaway:It’s a bull market. And consensus is nowhere near Bullish Enough.

POSITION:10 LONGS, 4 SHORTS @Hedgeye

Fundamentally, the most important data point this week was yesterday’s jobless claims report of 324,000. Our non-consensus bull case for US Equities continues to get more bullish as the market is rising. Weird, but cool.

Across our core risk management durations, here are the levels that matter to me most:

Immediate-term TRADE overbought = 1626

Immediate-term TRADE support = 1590

Intermediate-term TREND support = 1520

In other words, our model is now consistently signaling higher (all-time) highs of resistance and higher-lows of support. It’s a bull market. And consensus is nowhere near Bullish Enough.

Enjoy the weekend,

KM

Keith R. McCullough Chief Executive Officer

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05/03/13 10:58 AM EDT

Can The Dollar Continue Its Bull Run?

The US dollar is on a tear and is helping the US economy grow through consumption. Remember that Strong Dollar = Strong America. Lower commodity prices are a boon for the American consumer. With the PowerShares DB US Dollar Index Bullish ETF (UUP) up +2.25% year-to-date, there's plenty of room for the dollar to head higher.

NWL – Q1 Flattered by Tax Rate, Q2 and Q3 Likely Need to Come Down

NWL is on the tape this morning, and the quarter is decidedly unimpressive despite the optics of the better than consensus EPS result. Adjusted “core” sales grew 2.5%, right smack in line with the company’s annual guidance, but you have to torture the numbers a bit to get there. EPS was flattered by a lower tax rate, and the company changed the pacing of the quarterly EPS progression, so less Q2 and Q3 and more Q4.

Sale of underperforming businesses (Bulldog, Ashland, Amerock, etc.) should be accretive to margins as well as the company’s revenue growth profile (60 bps accretive to top line based on the last three years and 40 bps accretive to EBIT margin)

Strategic spending behind the brands set to accelerate sequentially through 2013

What we didn’t like:

In Q1 2012, the company called out the timing shift of $28 million in sales associated with the European SAP conversion (pulled forward from Q2 into Q1). This quarter, the company “normalized” the Q1 2012 income statement for SAP, rather than simply calling out the tougher sales comp. It appears to us the company got the “benefit” of higher EPS last year, and this year wants to flatter the year over income statement comparisons by normalizing EPS. It isn’t sitting right with us.

Writing business to suffer from consolidation of the U.S. office superstore channel (“overhang on the U.S. Writing business for some time to come”). The company was asked about this specifically at CAGNY and stated it wouldn’t be a factor – it appears to be now.

Guided down Q2 and Q3 (“normalized EPS will be much more evenly distributed across the remaining three quarters of the year then it has been in past years”) – this implies a lower Q2 and Q3 and a higher Q4 – have to watch consensus here.

Our expectations were modest for the quarter, and the company managed to slide in under them, but there wasn’t anything in the quarter sufficient to move us off our decidedly positive view on the name. We can still see a path to $1.80 per share in FCF over time and a stock price that more appropriately reflects the average staples multiple of FCF (15-20x).

Call with questions,

Rob﻿

Robert Campagnino

Managing Director

HEDGEYE RISK MANAGEMENT, LLC

E:

P:

Matt Hedrick

Senior Analyst

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